Bru

nn

erm

eier

–C

entr

al B

anki

ng

The Evolving Role of Central Banking

by

Markus K. Brunnermeier

Princeton University

Bruegel 2016 Brussels, Jan. 18th, 2016

Bru

nn

erm

eier

–C

entr

al B

anki

ng

Macro-Management

Price stability

Financial stability

Fiscal debt sustainability

Welfare

Growth Risk Distribution

Bru

nn

erm

eier

–C

entr

al B

anki

ng

Roadmap

1. From a stock-flow to a risk perspective• Banks as money creators and “risk mitigators”

• Amplification due to balance sheet impairments (bottleneck)

2. From a representative agent to a bottleneck perspective

3. Quantity vs. Prices

4. Independence – three dominance concepts

5. Size of Central Banks’ balance sheet

6. ZLB and Liquidity trap

7. MoPo and MacroPru interaction

Bru

nn

erm

eier

–C

entr

al B

anki

ng

A L

Ris

ky C

laim

A LR

isky

Cla

im

1. From Level to Risk Perspective Borrowers

…

Net worth

Inside Money(deposits)

A L

Reserves Pass through

Ris

ky C

laim

Ris

ky C

laim

Ris

ky C

laim

The Loanable Funds Model

A L

𝐵1

Money

Ris

ky C

laim

Insi

de

equ

ity

LL

LA L

Money

HH

Net

wo

rth

Savers

Money creation (inside money) depends on risk bearing capacity Demand for money rises if idiosyncratic risk cannot be diversified Amplification/endogenous risk

AA

A

Bru

nn

erm

eier

–C

entr

al B

anki

ng

A L

Ris

ky C

laim

L

Ris

ky C

laim

1. From Level to Risk Perspective

…

Net worth

Inside Money(deposits)

A L

Reserves Pass through

Ris

ky C

laim

Ris

ky C

laim

Ris

ky C

laim

A L

𝐵1

Money

Ris

ky C

laim

Insi

de

equ

ity

A

Bru

nn

erm

eier

–C

entr

al B

anki

ng

Banks as Risk mitigators Money creator

(inside money) depends on risk bearing capacity

Demand for money if idiosyncratic risk cannot be diversified

Amplification/endogenous risk

A L

Ris

ky C

laim

L

Ris

ky C

laim

1. From Level to Risk Perspective

…

Net worth

Inside Money(deposits)

A L

Reserves Pass through

Ris

ky C

laim

Ris

ky C

laim

Ris

ky C

laim

A L

𝐵1

Money

Ris

ky C

laim

Insi

de

equ

ity

A

Bru

nn

erm

eier

–C

entr

al B

anki

ng

2. From an Average to a Bottleneck Perspective

Identify bottleneck which may lead to amplification• Financial sector• Household sector in 2000s the US • Corporate sector in Japan 1990s

Ex-post repair “sector-aggregate” balance sheet• E.g. QE2 in US supported house prices

helped households (most effective) Not useful for Japan

Transmission channel might be “sectorially impaired”• Monetary Transmission Mechanism works differently

across sectors/regions• SME are disadvantaged compared to sovereigns and large

corporations

Bru

nn

erm

eier

–C

entr

al B

anki

ng

3. Quantities vs. Prices: a) Vulnerabilities

Watching: Vulnerability Indicator (build-up phase)

Trigger vs. Amplification• Triggers: varies subprime, internet,

• Amplification: common liquidity mismatch

Prices vs. Quantities• Prices follow trend, but Quantities show build-up of risk

Fundamentalquantities

Price

Vulner-ability

Price doesn’t move much…But is vulnerable to jump

Bru

nn

erm

eier

–C

entr

al B

anki

ng

3. Quantities vs. Prices: b) Target

Targeting: Fed funds vs. Repo rate• Reverse repo

Remoteness from risk for Central Bank

Should Central Bank assume risk and thereby reduce endogenous risk?• Assume small amount of risk and reduce endogenous risk by a

big amount

Bru

nn

erm

eier

–C

entr

al B

anki

ng

4. Independence of Central Bank

Monetary dominance• Fiscal authority is forced to adjust budget deficits

Fiscal dominance• Inability or unwillingness of fiscal authorities to control

long-run expenditure/GDP ratio

• Limits monetary authority to raise interest rates

0/1-Dominance vs. battle: “dynamic game of chicken”11

Fiscal authority

Central Bank

Game of chicken

Bru

nn

erm

eier

–C

entr

al B

anki

ng

4. Independence & 3 Dominance Concepts

Monetary dominance• Fiscal authority is forced to adjust budget deficits

Fiscal dominance• Inability or unwillingness of fiscal authorities to control

long-run expenditure/GDP ratio

• Limits monetary authority to raise interest rates

Financial dominance• Inability or unwillingness of financial sector to absorb losses

Refusal to issue no equity – pay out dividends in early phase of crisis12

Fiscal authority

Central Bank

Game of chicken

FinancialSector

recap Redistributive MoPo (i, QE, ….)

Bru

nn

erm

eier

–C

entr

al B

anki

ng

4. Independence: 2nd Game of Chicken

Monetary dominance• Fiscal authority is forced to adjust budget deficits

Fiscal dominance• Inability or unwillingness of fiscal authorities to control

long-run expenditure/GDP ratio

• Limits monetary authority to raise interest rates

Financial dominance• Inability or unwillingness of financial sector to absorb losses

Refusal to issue no equity – pay out dividends in early phase of crisis13

Fiscal authority

Central Bank

Game of chicken

FinancialSector

recap Redistributive MoPo (i, QE, ….)

2nd Game of chicken

Bru

nn

erm

eier

–C

entr

al B

anki

ng

5. Size of CB’s Balance Sheet

Should size of CB’s balance stay large?

Who should do maturity transformation of risk-free government debt? • Central bank or private sector (money market funds)?

• Need of a safe government asset (ESBies)

Maturity Rat race (Brunnermeier & Oehmke)

• Private sector is not good at maturity transformation• Informational value of interbank market is only for high

frequency movements, but not long-run build up of imbalances.

Bru

nn

erm

eier

–C

entr

al B

anki

ng

6. ZLB & Liquidity trap

Difficulty in creating inflation due to

Zero Lower Bound

Liquidity trap (more generally)• Risk bearing capacity is impaired

• Endogenous risk is rising

Bru

nn

erm

eier

–C

entr

al B

anki

ng

7. MacroPru & MoPo Interaction

MoPoasset prices distortion• Insurance/recap sector risk -- The I Theory• Impacts jointly:

risk taking, endogenous risk and risk premia

MacroPruquantity restrictions• Control risk taking (quantity) separately from risk premia

MacroPru complements MoPo• Not substitutes

Good MacroPru enables more aggressive MoPo• More redistribution ex-post• More risk-transfers/insurance ex-ante• Value of money is higher (lifts level)

Common MoPo in currency union –MacroPru can be state dependent

Bru

nn

erm

eier

–C

entr

al B

anki

ng

Conclusion

1. From a stock-flow to a risk perspective• Amplification due to balance sheet impairments (bottleneck)

2. From a representative agent to a bottleneck perspective• Ex-post: Redistribute• Ex-ante: Insurance

3. Quantity vs. Prices• Watch for vulnerability build-up• Target rates. Which? Should central bank assume risk?

4. Independence – three dominance concepts

5. Size of Central Banks’ balance sheet• Safe government asset – ESBies• Who should do maturity transformation of safe asset

6. ZLB and Liquidity trap

7. MoPo and MacroPru interaction

Bru

nn

erm

eier

–C

entr

al B

anki

ng

Redistributive Monetary Policy(New) Keynesian

Demand ManagementI Theory of Money

Risk (Premium) Management

Stimulate aggregate consumption Alleviate balance sheet constraints

Woodford (2003) Tobin (1982) BruSan

Price stickiness & ZLBPerfect capital markets

Both Financial frictionsIncomplete markets

Representative Agent Heterogeneous Agents

Cut 𝑖 ⇒ reduces 𝑟

Euler equation ⇒ 𝑐(substitution effect)

Cut 𝑖Changes bond pricesRedistributes from low MPC to high MPC consumers

Cut 𝑖 or QEChanges asset pricesEx-post: Redistributes

(wealth effect)(depend on asset holdings)

Focus on levels Focus on levels and risk dynamics